In a market economy, business deaths are like death itself - an unfortunate but inevitable fact of life. However, recent government bailouts have tried to stop the inevitable by intervening in the market, at least temporarily saving failed firms from the economic grim reaper. Before putting the next failed business on life support, it’s worth remembering why it makes sense to let struggling producers expire.
• When failing businesses are allowed to fail, resources are released from employments where they don’t add value and made available for employments where they do.
Resources used for one purpose can’t be used for another. Thus, it’s important that they find their way to the purposes we value most. Enter the profit-and-loss system. Under this system, when producers use resources in ways that are consistent with our wants, they earn profits. When they don’t, they earn losses. If losses are severe enough or accumulate over time, the producers who earn them go under.
Far from cause for concern, this failure is cause for celebration. When ineffective producers fail, resources committed to producing goods we value less are freed for producing goods we value more. Polaroid’s failure released resources for the production of digital cameras; Commodore Computers’ failure released resources for the production of IBM computers; and Chi Chi’s restaurant’s failure released resources for, well, the production of food that tastes good. Who better to sacrifice the resources required to expand production of the things we want than producers of the things we don’t?
If government prevents failing producers from going out of business, resources get “stuck” in employments where they’re less productive. We can’t have as many of the products we care more about because the means needed to make them remain locked in the manufacture of products we care less about. Society suffers as a result.
• When failing businesses are allowed to fail, producers learn how to combine resources in ways that create wealth.
We take it for granted that producers know what we want. But this information doesn’t appear magically. It has to be produced. The profit-and-loss system produces this information - but only when government lets failing businesses fail.
Profits and losses do for producers what traffic signals do for drivers. They tell them when to “go,” “slow down” and “stop” their productive activities. By communicating which resource combinations consumers value most and which they don’t, profits and losses direct “economic traffic,” informing producers how to produce.
If government prevents ineffective producers from failing, the red light on the “economic traffic signal” stops working. Production continues and resources flow when they should halt, destroying wealth instead of creating it.
• When failing businesses are allowed to fail, producers have incentives to combine resources in ways that create wealth.
The profit-and-loss system works because successful producers reap rewards when they combine resources effectively and unsuccessful producers incur costs when they don’t. The prospect of profits from making good decisions and losses from making bad ones encourages producers to make choices that improve our lives.
But if government shields ineffective producers from the consequences of their bad decisions, producers’ incentives become skewed. For instance, when policy permits producers to enjoy the benefits of successful risk-taking but subsidizes the losses of unsuccessful gambles, producers have an incentive to take on more risk than they should. Since they’re no longer responsible to consumers when they make poor choices, the link connecting producers’ and consumers’ interests is weakened and, with it, the economy’s ability to advance.
At a time when failure is the new dirty word and government seems willing to prop up floundering firms at any cost, we would do well to remember the benefits of letting failing businesses go belly up.
Peter T. Leeson is BB&T Professor for the Study of Capitalism at George Mason University and author of the new book, “The Invisible Hook: The Hidden Economics of Pirates.”.